Commodities: A Crude Awakening

Commodity prices have been under significant pressure over the last year, due to a multitude of factors. Emerging market growth has been disappointing. Decelerating growth in China (see the blue line in Exhibit 1) has led to a shortfall in demand. OPEC has kept their pumps running full speed despite the demand shortfall, in an apparent attempt to slow U.S. fracking, leading to a plunge in oil prices; the strengthening dollar (orange line in Exhibit 1) has also hurt commodity prices. The resulting poor return of commodity-related investments has caused some investors to question both the short-term and long-term merits of natural resources investments. We do have a tactical underweight recommendation (12-month time horizon) for commodities, due to the soft demand outlook and the negative impact of the strong dollar. However, our strategic recommendation (5-year outlook) supports an allocation to commodities as we expect some tightening of supply to improve prices over the longer term. The recent selloff in the commodities complex has improved the current valuations of commodities-related stocks. In addition, we think commodities provide an effective hedge against the risk of inflation. Finally, our strategic recommendation is based on an equities-based approach to investing in commodities, as opposed to a futures-based approach. We believe that investing in the equity of commodity producers (such as energy, mining, chemical, agriculture and water companies) will produce a superior return over a futures-based approach, while still providing good inflation protection.

The commodity complex is a heterogeneous one, with respect to both the varied types of commodities and the indexes that measure aggregate performance. Because we believe that inflation protection is one of the primary attributes of commodity investing, we favor a benchmark that highly correlates with inflation trends – the Morningstar® Global Upstream Natural Resources Index. To lend some insight into this occasionally misunderstood asset class, we show some of the key attributes of this index in Exhibit 2. Firstly, it is well diversified amongst industries. Oil and gas (energy) comprises 31% of the index, as compared to over 70% for the S&P GSCI® Commodity Index. Agriculture and farm products comprise another 29%, and movement in the price of these commodities is driven by different factors than the other commodities. The final large component is industrial metals and minerals, which contribute 18% to the index. The geographic exposure appears well diversified, but this is somewhat misleading as it represents the home listing country of the stocks in the index. There is clearly much greater exposure to emerging market growth in the end-demand of these companies than is reflected in their home countries.

The top 10 companies represent 39.4% of the index, with another 110 companies making up the remainder. We show the largest companies in the index to highlight that this investing approach to commodities involves owning operating companies, as opposed to investing in futures contracts on commodities. We believe an advantage of this approach is that investors are exposed to the economic returns that the operating companies generate, and still retain sensitivity to inflationary trends. This is in contrast to the futures-based approach, where your prime assets are derivatives contracts and the collateral that supports them (usually being invested at de minimis interest rates).

The best run of these companies will focus on maximizing shareholder value and maintaining dividend payouts, even during a downturn in commodity prices. The major oil and gas companies have a strong record of dividend payouts, during oil bear markets. The bear market in oil prices in the mid-1980s was comparable to the current environment, and neither Exxon nor Chevron cut their dividends back then. Should Brent crude prices stick near the current level of $49/barrel, the focus on dividend sustainability will rise. However, in the current environment, we would expect capital expenditure cuts to occur before dividend cuts, and we think crude prices could fall toward $25/barrel before we’ll see dividend cuts at the top-tier producers. The agricultural input companies should also have a relatively stable dividend outlook. Their balance sheets tend to be stable and pricing is better than in the industrial metals space. Industrial metals company dividends have the most uncertainty, and further price weakness would materially raise the risk of dividend cuts.

Exhibit 3 highlights the longer-term realized return differential between the two approaches to commodity investing. While the excess return year-to-date has been minor, the annualized differ-ential over all other periods has been considerable. On a 3-year and10-year horizon, the equity-based approach has outperformed the futures-based approach by roughly 10 percentage points per year.

Our strategic positioning in commodities (or referred to as natural resources when using an equity-based approach) is a reflection of our belief that the next five years will differ from the past year. As readers of our annual capital market assumptions whitepaper (Five-Year Outlook: 2015 Edition) know, valuations play a big role in our longer-term expectations for asset class returns given their predictive power over a five-year time frame. Exhibit 4 shows the current discounts in the natural resource sector vs. the broader equity markets given the recent sell-off.

We estimate the current cash flow yield for natural resources to be 13.2%, above the median level of 12.0% since late 2000. Relative to global equities, natural resources stocks have a cash flow yield of 144% of the market yield, compared with a median level of 115%. The dividend valuation is similar, with a current yield of 3.0% and a relative yield of 124% compared with a median of 82% over the last 15 years.

Since these valuation measures are based on trailing values of cash flow and dividends, they are subject to pressure should earnings continue to fall. Currently, consensus estimates for both energy and materials are for an earnings rebound in 2016 of 29% and 14%, respectively. While there is clearly risk to the 2016 estimates, we do think that current valuations provide some cushion for longer-term returns, so long as the fundamentals within the space do not deteriorate further during that time frame. Per our “Slow Burn of Low Growth” theme, we do not expect – nor does our forecast require – a surge in demand for natural resources over the next five years.

If we felt that a demand surge would occur, we would have increased our five-year total return forecast; we instead kept it steady at 7.0% (though it did make the asset class more attractive in asset allocation modeling as most other risk asset forecasts fell). Rather, we believe a demand profile consistent with our low growth (but not recessionary) five-year outlook – combined with longer-term supply issues – will be sufficient to induce a modest cyclical upswing in commodity prices over the next five years. This expectation is consistent with the cyclicality witnessed in commodity prices going back to the early 1970s, which was only interrupted by the emerging market-driven commodity super cycle during the late-2000s (Exhibit 5).

The difference between our cautious tactical outlook and our more constructive strategic outlook for underlying commodity prices comes down to the economics of commodity extraction. In the near term, fixed costs are sunk costs and producers will continue to produce so long as they are cash flow positive (revenues exceed the direct costs required to produce those revenues). Longer term, new projects will not be taken on unless they also cover the fixed costs. This will require higher commodity prices to overcome the higher cost hurdle. It is important to remember that most commodities are consumed. Thus a slow growth (or even no growth) environment does not remove the need to discover new resources for commodities that have finite supplies readily accessible.

Beyond the long-term, valuation-driven opportunity, we believe a strategic allocation to natural resources is supported by the risk management attributes it brings to the investment portfolio. Many economic disruptions are caused by events that actually benefit the natural resources asset class. Weather aberrations may push food prices up, hurting consumer spending and overall economic demand but benefitting those companies with agriculture exposure. Social unrest may lead to emerging market energy production disruptions, impairing economic functioning but benefitting oil producers.

Overall, futures-based commodities and equity-based natural resources remain the best protection against inflation as seen in Exhibit 6, which shows the correlations over the past 10 years of year-over-year asset class returns to year-over-year inflation – both on a coincident and three month-lagged basis (to account for the market discount mechanism). Our other primary real assets, global listed infrastructure and global real estate, provide cash flows that can adjust for inflation, but at the total return level, do not exhibit the same levels of correlation to inflation that commodity strategies do. While neither we, nor the markets, anticipate major inflationary pressures in the near term or longer term, we believe a well-structured strategic portfolio should provide protection against unexpected events and would remind strategically oriented investors that the best (i.e. cheapest) time to take out an insurance policy is when you don’t think you need it.

Going beyond our top-down outlook for natural resources, the three major natural resource sectors (energy, industrial metals and agriculture) have specific long-term considerations. The energy sector is currently oversupplied due to some slowdown in demand and the increased supplies from fracking in the United States. However, excess supplies from fracking activities are not expected to persist longer term given expected depletion rates that are much higher than conventional oil fields (upwards of 25% per year in some cases vs. the broader 4% level). Even when assuming just a 4% depletion rate, a 1% demand growth expectation (a conservative estimate, in part due to potential substitution to other forms of energy) means 36% of current oil production will need to be replaced by 2020. This will require new investment – and higher prices to justify that investment. Industrial metal production benefitted from a massive infrastructure buildout as company management teams simply extrapolated high Chinese demand growth into the future. Chinese demand has, of course, slowed leaving an oversupplied situation. However, as companies reduce investment in the wake of slower Chinese demand, the industry is setting itself up for a cyclical rebound; many industrial metals are already priced below estimated marginal costs, let alone higher total costs should new investment be needed down the road. Industrial metals are not “consumed” the same way energy and agricultural commodities are (a bridge lasts for decades, a meal lasts for a few hours); therefore, new demand will need to play a bigger role. Some potential areas of incremental demand include global infrastructure needs and China’s “One Belt, One Road” initiative, but the slowdown in the industrial metal needs of broader China needs to be remembered.

Agriculture demand over the next five years is more certain than either energy or industrial metals demand, given the fact that agriculture is consumed and there are few substitutes (the transition in emerging market diets from grains to protein only increases the demand for agriculture products given the grain-intensity of raising livestock). Agriculture supply will be driven by weather aberrations (which cannot be predicted, but it can be reasonably assumed that they will continue) and genetically modified organism adoption (wherein some factions are throwing up roadblocks but it may be the only way to feed a growing population).

CONCLUSIONThe short-term picture for commodity investing remains challenging. Our expectations for disappointing emerging market growth and strengthening in the U.S. dollar both point to the potential for further commodity price weakness, leading to our tactical underweight to the asset class. We view the recent decision by China to devalue the Renminbi as further justification for our tactical positioning. However, with the sell-off in commodities comes a better valuation picture and an improved long-term return potential. We think commodities improve the risk/reward characteristics of a diversified portfolio by providing the best inflation protection of the major asset classes. In addition, we think the fundamental case for the supply/demand picture for the major commodities should improve over the five-year strategic timeframe, supporting their performance. Finally, we strongly favor an equity-based investment approach to commodity investing, as it has generated superior returns to a futures-based approach.

Special thanks to Edward Trafford and Jackson Hockley, Senior Equity Research Analysts, for their insights into the commodity complex; and also to Tyler Bullen, Investment Analyst, for data research.

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November 11, 2014

Mood Swings

While market volatility has been well below average over the last two years, we have seen a spike in daily moves greater than 1% over the last month (as shown in Exhibit 1). In fact, if one annualized the October 1% market moves, the frequency would approach the levels of 2008 and 2009 (although the frequency of moves of greater than 2% would be lower). This pickup in volatility has led some investors to ask what this means for future market returns, and whether there are reliable signals that can help divine the next correction in the market. We recently reviewed the efficacy of various market indicators, like investor sentiment, volatility and margin debt, and found there is only modest value that can be gained from analyzing investor sentiment indicators. We also examined a more fundamental building block  valuation  as a timing tool, and found that while valuation has little near-term value in predicting market returns, it is valuable on a long-term basis. For this reason, we look to valuations to help forecast long-term returns. The markets that have been underperforming U.S. equities are generally trading at relatively attractive valuations  increasing their long-term return potential. This bolsters the case for a strategic allocation to these markets, and cautions against throwing in the towel on underperforming regions.

EXHIBIT 1: VOLATILITY SPIKESSources: Northern Trust, Bloomberg. Big move trading days are market moves of more than 1%. Historical averages are from 1972 to present.

In Exhibit 1, we define big move trading days as days when the market moves by more than 1.0% (up or down). For context, this equates to a 175 point day on the Dow Jones Industrial Average at current price levels. Looking at big move days helps put the concept of standard deviation into a more understandable framework. For instance, MSCI World volatility  as measured by standard deviation  during the 2008-2009 time frame was 25.6%. But perhaps more relevant was the fact that markets suffered 61 and 46 days of greater-than 1.0% declines in 2008 and 2009, respectively  versus the historical average of 19 days a year with losses of that magnitude. Lately, we have enjoyed a below-average number of down days  with only 12 in 2013 and only 12 in 2014 (through October 31). However, looking at the monthly numbers, we clearly saw a spike in October  both in terms of up days and down days (four each). Is there anything volatility  and other sentiment indicators  can tell us about the future path of the markets?

In Exhibit 2, we analyze the relationship between volatility and subsequent market performance by looking at the monthly Chicago Board Options Exchange S&P 500 Volatility index level (VIX) against subsequent one- and 12-month S&P 500 returns. Splitting the VIX levels into three buckets shows that no significant difference in future returns exists. The R-squared between the VIX and next 30-day returns is just 0.03, meaning that it only explains approximately 3% of S&P 500 return variability. Meanwhile, the longer-term measure is even worse with an R-squared of just 0.004, meaning the VIX explains approximately 0.4% of S&P 500 return variability. The range of realized returns does, however, increase as volatility rises.

As we dig deeper into the details, we see further evidence that this is not a very predictive model. For example, when the VIX reaches 26, the expected return is around 11%, but ranges between -40% and 20%. Interestingly, when the VIX rises above 40, market returns have been positive 100% of the time on a 12-month basis. However, the 30-day returns illustrate that you would have to take some short-term pain before realizing this longer-term gain.

Along with the strong rise in the markets over the last five years, margin debt has been accelerating and has become a recent concern of investors  both because of the elevated levels it has reached on a nominal basis (currently at $464 billion) and the way in which previous peaks in margin debt have coincided with substantial downturns in the markets. However, looking at the level of margin debt when scaled by the size of the U.S. equity markets (using the S&P 500 market cap as our proxy) paints a less dramatic picture (see right panel of Exhibit 3). By this measure, current levels of margin debt are more or less consistent with the trend line over the past 20-plus years. This secular upward trend is most likely a reflection of continually falling interest rates (and, thus, falling margin debt servicing costs). Other secular factors at play include the proliferation of hedge funds (hedge fund data is included in the margin debt metrics) and financial innovation whereby taking on margin debt today comes with substantially less friction than in the past.

Turning to the prospect of the recent run-up in margin debt signaling an imminent downturn in the markets (as appeared to happen in 2000 and 2007), we are less convinced. Again, on a relative basis, current margin levels are fairly contained. Furthermore, we cannot be certain of the cause and effect of the recent margin debt peaks. We believe it is more likely that the market sell-offs caused the reduction in margin debt and not the other way around. Because margin debt can be used for betting against as well as betting on the market  and can even be used for things that have nothing to do with the market (e.g. an individuals desire to consume)  it makes sense to dive into indicators that provide a better read on investor sentiment. We discuss three in particular: investor sentiment surveys, put/call data and fund flows.

As a measure of individual investor sentiment, the American Association of Individual Investors (AAII) asks individual investors whether they are bullish, bearish or neutral on stocks over the next 6 months. Individual investors do tend to be a reasonable contrarian indicator  as their moods tend to reflect what has already happened in the markets as opposed to what is about to occur. During periods where investors were excessively bearish or bullish, the surveys have been a fair market timing indicator. When theres excessive bearishness in the surveys, the median market return over the next month is 23.3% (annualized), and over the next 12 months is 16.2%. When theres excessive bullishness, the return over the next 30 days is just 3.8% (annualized), and over the next 12 months is 9.4%. Investing during periods of excessive bearishness had a 58% (one month) and 65% (12 months) probability of outperforming the markets normal-sentiment returns. This strategy has a reasonable hit rate, or probability, of success when looking at the 12-month returns.

When we use a stricter definition of excessive bearishness  a two standard deviation move  the S&P 500 returned 29.8% over the next 30 days (annualized, with a 66% hit rate) and 23.0% over the next year (a 69% hit rate). This is a rare event, happening only 35 weeks in the history of survey. The last time there was a two standard deviation level of bearishness was in March 2009  and the S&P 500 subsequently gained 65% over the next 12 months.

EXHIBIT 4: SENTIMENT INDICATORS LOOK MORE USEFUL THAN THEY ARESources: Northern Trust, Bloomberg, Morningstar. AAII surveys: weekly since July 1987; CBOE puts and calls: daily since January 1997; Morningstar flows: monthly since February 1993. Three-week smoothing used for survey and puts and calls data.

We next turn to daily put and call volume on the Chicago Board Options Exchange (CBOE), focusing on call volume (bullish bets on the markets) as a percent of total put and call volume. To reduce the impact of professional institutional hedging activity, we excluded index option volume. Our analysis shows that analyzing put and call option volumes is a less useful indicator than individual investor sentiment surveys.

When the CBOE reported excessive call volume, the median market return over the next 12 months was about 7.7%, actually above the 7.2% return when there was excessive bearishness. The distribution was non-normal  excessive bullishness only happened 4.6% of the time, while excessive bearishness happened 31.7% of the time. Markets tend to have more call writers than put writers  and data dont appear to be mean-reverting  as there has been a slight downtrend over the last 15 years, possibly reflecting the increasing presence of long-short equity hedge fund strategies. This study performed better on a 30-day basis as the median return during excessive call-writing was a negative 9.8% (annualized) over the next 30 days, versus 15.9% when there was excessive put-writing. The hit rate of reducing equity exposure during a bullish market was nearly 60%, which isnt bad but would require a long-term systematic program to capitalize on it.As a final gauge of sentiment, we looked at the flow of money into and out of risk assets (e.g. stocks) and risk-control assets (e.g. bonds). We included U.S.-domiciled open-ended mutual funds, ETFs and money market funds. Fund flows can be a solid contrarian indicator on a 12-month horizon. The median market return when investors are taking risk off the table is 13.6% over the next 12 months  better than the 11.4% return when risk is on, but with just a 56% hit rate. On a 30-day basis, the market has outperformed when more money is flowing to risk assets (14.7% versus 10.7%, annualized), a logical occurrence since fund flows can be a technical contributor to short-term momentum.

While sentiment can swing markets in the short-term (one year or less), over a long-term horizon (five years or more) the single best predictor of equity market return variation that we can find is valuation. Cash flow yield is our preferred valuation measure to assess valuation levels. Given its recent popularity, we also assess the cyclically adjusted price-to-earnings ratio (CAPE), which uses a 10-year rolling earnings number for earnings. Looking at the data on a one-year basis shows that valuations provide little insight  with cash flow yields and CAPE explaining only 11% and 7% of return variability, respectively. However, on a five-year basis, cash flow yields and CAPE explain 43% and 37% of return variability, respectively. Coincidentally, both valuation measures currently predict a 6.4% annual return for U.S. equities over the next five years, below the 10.1% long-term historical average (data back to 1926). As we include valuations in our Capital Markets Assumptions work, this is fairly close to our forecasted 6.6% return for U.S. equities.

In Exhibit 5, we convert the CAPE to an earnings yield figure to provide comparability with the cash flow yield data. Many investors are concerned about the heights CAPE has reached, currently standing at 26.3. Since 1881, the CAPE metric has only surpassed this level on three occasions, with peaks occurring in 1929, 1999 and 2007  all preceding major market drops. However, some (including us) question the validity of the CAPE in the current environment given the massive fall in earnings during the financial crisis (the 2008 earnings still suppress the 10-year earnings figure). Furthermore, while CAPE is currently stretched, it has been that way for some time  with the metric sitting above 20 since 1995, with a brief exception during the financial market crisis. As Robert Shiller, the co-developer of the CAPE ratio, said in an August 17, 2014 NY Times article The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop  is hovering at a worrisome level. However, he went on to say The CAPE was never intended to indicate exactly when to buy and to sell. The market could remain at these valuations for years. But we should recognize that we are in an unusual period, and that its time to ask some serious questions about it. In our opinion, it seems as if Professor Shiller also believes the CAPE is a good long-term predictor of returns, but not a short-term trigger.

Valuations are one major component of our Capital Markets Assumption (five-year) return expectations, alongside earnings expectations and dividend yield assumptions. Looking at developed markets, we expect similar earnings growth across the various regions (approximately 5%). While we do expect Europe and Japan to show slower economic growth than the United States, the composition of company revenues in those regions allows better earnings potential than would be suggested by the companys country of domicile. For instance, companies in slow-growing Europe get nearly 50% of their revenues from outside of the European bloc (including nearly a quarter of their revenues from emerging markets) making those companies the most geographically diversified of all regions (by comparison 70% of U.S. company revenues come from the United States).

1Shiller, Robert J. The Mystery of Lofty Elevations. New York Times 16 Aug. 2014: BU3. Print.

While our earnings expectations across developed markets are similar, the forecasts for higher dividend yields in Europe, and slight multiple expansion, gives Europe a forecasted return advantage over the United States. Looking at emerging markets, the higher earnings growth potential (with 84% of revenues coming from domestic sources) alongside a solid dividend yield and some valuation expansion lead us to continue to expect a return premium out of those equities relative to the developed markets. The current sentiment toward many major equity markets outside the United States is soured by recent underperformance. However, the improved relative valuation increases the relative return potential and we think supports a better 5-year return expectation. We think this justifies a continued commitment to a globally diversified equity portfolio, which helps reduce dependency on any one region and reduces the risk of materially underperforming a global equity universe.

Special thanks to Raymond Luo, Investment Analyst, for data research.

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